Vanilla Options Explained
Options trading has often been considered a daunting endeavor and a reserve for elite investors but vanilla options have changed this perception. Also known as ‘plain vanilla options’ (due to their ease of understanding and simplicity of trading), they are contracts that give traders the right to buy or sell a specified amount of an instrument, at a certain price, at a pre-defined time. Vanilla options offer a great and unique way of trading the markets. Traders can control the instrument traded and the amount staked, as well as the price and duration of the trade. Options can be traded for a day, a week, a few months, or even for a year.
In the financial markets, where there is little that can be controlled, vanilla options offer traders a great deal of power over their trading activities. Numerous trading choices can be made, all aspects of the trade can be controlled, and traders can always manage the risks and rewards more effectively in the market.
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Key Vanilla Options Terminology
Here are some of the key terminologies to know when you are trading vanilla options. To start with, there are two main types of options:
- Call Options, which are bought when the underlying financial asset is expected to increase in price. Call options are typically bought by bullish traders in the market.
- Put Options, which are bought when the underlying financial asset is expected to decrease in price. Put options are typically bought by bearish traders in the market.
You can buy or sell either type of option.
How to Own an Option
To own an option, the buyer pays the seller an amount which is known as the premium. When a trader acts as the buyer, they pay the premium, and when selling an option, they receive the premium. The amount of premium paid depends on several factors such as:
- the price of the underlying asset,
- the time left until the expiry of the trade (since options are contracts to trade in the future), and
- the volatility of the underlying asset.
Options contracts have a pre-set time limit. The date on which the option can be exercised is called the expiration date, and the price at which the option buyer can choose to execute is the strike price. Typically, longer-dated options have higher premiums than shorter-dated options. This is because the longer the period to expiry, the better the chances of a trade achieving its objective.
Volatility is simply the degree of price fluctuations in the market. Market volatility is one of the most important factors in determining the premium of an underlying financial asset. Volatility is usually a measure of risk, but in vanilla options, it presents opportunities for traders. Higher volatility increases the value of an option premium because it increases the likelihood of a potentially big move that will generate profits. Both historical and implied volatility can determine the premium of an option. A trader can always decide to close a vanilla option trade at any given time to profit from a higher premium, whether it was a consequence of volatility or simply a favorable price movement in the market.
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The Basics of Vanilla Options Trading
When buying an option – whether a call or a put – the trader pays the premium beforehand. This comes from the trader’s account balance. The maximum risk when buying an option is the amount paid as the premium, but the potential reward is limitless. On the other hand, when selling an option, the trader receives the premium beforehand. In this way, the premium received is the maximum possible reward, whereas the trader is exposed to limitless risk in the market.
A profitable option contract is said to be ‘in the money’; whereas a losing option contract is said to be ‘out of the money’. When you buy calls, your contract will be in the money when the underlying asset price is above the strike price. Likewise, a put option contract will be in the money if the price of the underlying asset is below the strike price. As explained above, there is an element of risk when trading options. But traders can limit risks by using stop-loss orders, just like in other spot trade positions. Alternatively, traders can limit their potential exposure by buying options contracts that are further out of the money.
Steps in Vanilla Option Trading
- The first step in trading options is establishing the overall market view or sentiment for the underlying financial asset. If, for instance, a trader believes that the asset’s price will increase, they can express that view in three ways. The first would be to buy the asset outright through the regular spot trading market.
- The second way is to buy a call option. In this way, the upfront premium amount paid represents the maximum risk incurred in the market. A call option is the safest way to express a bullish view in the market, and it can always be sold at any time.
- The third way is to sell a put option. If the underlying asset’s price is higher than the strike price at expiration, the option will expire worthless – and the trader keeps the entire premium they collected upfront.
Scenario: The current price for the AUDUSD pair is 0.8000. The trader speculates it will rise within the week.
Spot Trade: In the first case scenario, the trader will open a spot position for 10,000 units, on the platform at the given spreads. If the AUDUSD pair price moves higher, the trader instantly earns a profit.
Buy Call Option: In the second strategy, the trader buys a call option with one week to expiration at a strike price, for example, of 0.8020. Once buying, the trader pays the premium as shown on the trading platform of, for example, 50 pips or 0.0050. If at the expiration date, the AUDUSD pair exceeds the strike price, the trader will earn the difference between the strike price and the prevailing AUDUSD rate. The breakeven point is the strike price plus the upfront amount paid as a premium. The higher the price moves (further from the strike price), the more profits the trader makes. The trader can also profit at any time before expiration due to an increase in implied volatility or a general move higher in the AUDUSD rate.
For example, if at expiration the AUDUSD pair is trading at 0.9000, the trader’s option will be 0.0080 or 80 pips “in the money”, and the profit will be 80 pips minus the premium the trader paid of 50 pips. On the other hand, if the spot price is below the strike price at expiration, the loss will be the premium the trader paid, 50 pips, and no more.
Sell Put Option: In the third strategy, the trader will sell a put option. In this way, the trader will receive the premium, as a seller, directly into their trading account. Using this strategy, the trader must be careful about selecting an appropriate strike price. It should be a price point that the trader firmly believes the AUDUSD pair will not fall below. This essentially means that the trader must be comfortable buying the AUDUSD pair at the strike price if the spot finishes lower. The option seller receives the premium beforehand because of the risk he/she assumes in the market. If the spot finishes higher, the seller gets to keep the premium and they can sell another put to add to the income earned on the first trade.
In both scenarios, the premium is set by the market, and the AvaOptions trading platform will display the amount at the time of the trade. Profits and losses based on the strike price will be determined by the price of the underlying asset at expiration.
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Why Trade Options?
Options trading is considered relatively safer than other types of investments, such as spot trading. For an option buyer, the maximum possible risk is the premium paid; and while there is a theoretically higher risk for an option seller, it is much safer than the exposure that spot trading provides. It is also worth noting that like other derivatives, options are also leveraged, but the leverage level is considerably lower, which also limits risk exposure in the market.
Additionally, options can also be used to hedge spot positions, thus effectively limiting the risks to the premium amount paid. For instance, if you have a long position on a financial asset such as gold, you can hedge that position by buying put options. Put options increase in value when the price of the underlying asset falls. This means that if your long spot market position on gold generates losses, your put option will generate profits, effectively mitigating the risk of market swings.
Express Any Market View
Options offer a unique and exciting way of trading financial assets. When trading options, you can express any market view efficiently, even when in doubt. By combining long and short call and put options as well as long or short spot positions, traders can limit risks and enhance profitability before the due date of the option approaches. If, for instance, you are bearish on the AUDUSD pair but not really convinced, you can buy put options with a longer expiration date to give your trade position enough time to play out. You can also combine it with a spot position to hedge or to boost your profits.
Multiple Trading Strategies
In most online trading, traders can only speculate that an asset can rise or fall. But in options, traders have much more room to try out various trading strategies using different factors, such as:
- the current price vs strike price,
- overall market trends,
- duration of trade,
- risk appetite, and more.
You effectively have much more power over your trading activity and investment fate. There are obviously risks and rewards when trading financial assets, but in options, the trader has more control in the fast and dynamic markets.
Additionally, options provide the best platform for executing volatility plays in the market. Volatility is a major risk factor when trading financial derivatives, but in options, traders can mitigate its risks by applying Strangle and Straddle strategies in the market which are considered efficient options trading strategies. Strangle strategies are usually applied when there is a directional bias in the market, whereas Straddle strategies are typically applied when there is no clear directional bias. Here are some of the ways Strangle and Straddle strategies are applied:
- A long strangle is implemented by buying both call and put options, with similar expiry times, but different strike prices. In this way, the maximum risk is capped at the premium paid for the two contracts, but the profit potential is theoretically unlimited.
- A long straddle is implemented by buying both call and put options, with similar expiry times as well as identical strike prices. The maximum risk is capped here as well, but the profit potential is unlimited if volatility results in big price movements of the underlying asset in both directions.
- Both short strangle and short straddle strategies are implemented when low volatility is expected at the price of the underlying asset. A short strangle is implemented by buying both call and put options, with identical expiry times but different strike prices. On the other hand, a short straggle is implemented by buying both calls and put options with similar expiry times as well as identical strike prices. In both strategies though, profits will be generated when the price of the underlying asset does not make significant movements in either direction (it ranges or consolidates).
Vanilla options provide a great way for investors to take advantage of price changes of financial assets in the market. Access free learning materials from the AvaTrade AU education section and build your options trading knowledge, skills, and techniques.
Increased Trading Choices
Options trading opens more possibilities for traders to trade their favorite financial assets with freedom and flexibility. Whether you are a conservative or aggressive trader, a beginner or experienced one, options trading offers a risk limited entry to the exciting and lucrative world of online financial assets trading. Use the innovative tools and products available on our AvaOptions platform and take your trading activities to the next level.
Vanilla Options with AvaTrade Australia
AvaOptions is a leading platform for trading options that were built with the trader in mind. The platform is user-friendly and intuitive, and it offers numerous handy features and tools to help you enhance your options trading activities. It is highly customizable and has key options trading strategies integrated for easy application by traders.
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